How UK interest rate predictions have shifted after the Brexit vote

Following today's announcement to hold interest rates from the Bank of England (BoE) Andrew Oxlade, Head of Editorial Content, looks at market expectations for the BoE's interest rate policy and answers five crucial questions:

14/07/2016

Andrew Oxlade

Head of Editorial Content

30 MinutesUnstructured Learning Time

The Bank of England (BoE) is expected to order a cut in the UK bank rate in August after holding fire at the July meeting, announced today.

The money markets (the implied forecasts from the Overnight Indexed Swap or OIS, taken at 1pm on 14 July 2016) fully price in a cut for August.

Trading also suggests a further reduction to 0% may be ordered in December, which has shifted from a forecast of November a week ago.

The expectation of lower rates marks a sharp turnaround from the mood in the months before the EU referendum when the focus was on trying to predict when the Bank’s key rate, at 0.5% since 2009, would rise rather than fall.

The markets had expected no rate increase until at least 2018 for much of the first half of this year. Now markets do not expect rates to even return to 0.5%, after the expected cuts, until the summer of 2020.

The Brexit verdict has dealt a shock to the system. It has increased the need to keep supporting the economy with low rates, the BoE has indicated.

The rate-setting Monetary Policy Committee (MPC) will next meet on Thursday (14 July).

Azad Zangana, Senior European Economist and Strategist at Schroders, said: “We believe August is the most likely time for a decrease in the bank rate. It gives the Bank of England more time to gauge the impact of the EU referendum. As we said earlier this week, the July meeting was too early to fully understand what the economic data is telling them.”

A poll of 53 economists by Bloomberg published on Friday (8 July) found most expecting a cut at the meeting this week:

24 expected hold

23 expected a quarter point cut

6 expected bigger cuts

Here we answer five crucial questions about interest rates.

How and why is the bank rate controlled?

The MPC is charged with using interest rates to balance the economy. It reduces rates to stoke demand and raises them to cool it. As part of this, it has an inflation target of 2%.

The MPC meets for three days once a month and looks at factors that may affect the economy and gauge what might happen in the future to the key consumer prices index (CPI) inflation figure.

From September, these meetings will be held less frequently - eight times a year.

Why has the rate been at 0.5% since March 2009?

The recovery from the financial crisis of 2008-2009 has been so fragile that the MPC has viewed it as necessary to keep rates at 0.5%.

Inflation has been below 2% since early 2014 and bumped around zero for much of 2015, way below the target. It is therefore judged that low rates and other ways of stimulating the economy are needed.

Levels of debt in the UK should also be considered. This is at historic highs for the UK government, as well as British consumers and companies.

Higher rates would dramatically increase the burden of those debts, thereby offering another major consideration for the MPC.

How does the bank rate affect other rates, such as mortgage and savings rates?

The bank rate is heavy influential on consumer rates, in fact some mortgage deals are directly linked to it. But other factors are at play.

Other schemes have been devised by the central bank with the aim of driving down borrowing costs.

These have included the quantitative easing (QE) programme begun in 2009 followed by the Funding for Lending Scheme (FLS) in 2012.

So while the bank rate has been fixed at 0.5% for more than seven years, mortgage and savings rates have tumbled.

They fell particularly sharply after FLS. Bank of England data shows that in the past five years, the average rate for two-year fixed rate savings bonds has fallen from 3.49% to 1.15%. The average overall mortgage rate has sunk from 4.39% to 2.52%.

The pricing of new mortgage and savings deals remain highly sensitive to expectations for the bank rate. As the chances of rate cuts have risen, lenders have responded.

Most notable has been a new price war on 10 year fixed-rate mortgages, with HSBC first offering a rate of 2.79%, followed almost immediately by a 2.39% deal from Coventry Building Society.

Some commentators have questioned the ability of banks and building societies to keep passing on rate cuts because lower rates come with slimmer profit margins.

What else is affected by interest rates?

One of the most significant impacts of rate adjustments is on currencies.

An anticipation of higher rates tends to drive a country’s currency higher while the prospect of a reduction will normally have the opposite affect.

This is because a higher UK bank rate will attract foreign investors, pushing up demand for sterling-based assets and thereby supporting the currency.

Many other factors also influence currency fluctuations, including economic strength and political stability.

Why cut rates after Brexit (and why not)?

The shock of the Brexit verdict runs the risk of damaging economic growth, spurring the MPC to act. However, the Bank has other measures it can deploy.

It has, for example, already relaxed capital buffers so banks can lend more and it could also restart its QE and FLS programmes. The MPC may also feel that the pound has fallen too far already.

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